The unleveraged ETFs (exchange traded funds) attempt to track the price of the commodity by holding the actual commodity in storage, or by purchasing futures contracts. Because futures provide leverage (more exposure than the actual cash invested), ETFs that use futures contracts have uninvested cash, which they usually park in interest-bearing government bonds. The interest on the bonds is used to cover the expenses of the ETF and to pay dividends to the holders.

The ETNs (exchange traded notes) are non-interest paying debt instruments whose price fluctuates (by contractual commitment) with the price of the commodity. In other words, with the ETN you don’t actually own the commodity, but a promissory note to pay you based on the commodity’s price. Because they are debt obligations, ETNs are subject to the solvency of the issuer.

The leveraged long ETFs and ETNs provide super-charged exposure to the commodity: if the goes up 3%, the leveraged ETF may rise 6% (and vica versa).

The short and leveraged-short ETFs and ETNs are a way to bet against the commodity price: if the price falls, the short or leveraged short ETF or ETN rises, and vica versa.

Why & How To Use Them

Commodities are a separate asset class from stocks and bonds, so they provide extra diversification in a portfolio.

The case for oil and gas: a hedge against inflation, and a play on economic growth, rising demand and future supply shortages.

The case against: In contrast to stocks and bonds, commodities are not income generating. So ownership of the ETFs or ETNs is a pure bet on prices. And the expenses charged by the ETF and ETN providers, including the cost of managing the futures, eat away at the underlying value of the fund. Morever, in the past, the price of oil and gas have underperformed the stock and bond markets for extended periods.

What to Look Out For

Long ETFs that use futures have diverged significantly from the price of the commodities themselves. ETNs, in contrast, track the price of the commodities closely. See the articles in the Further Reading section below.

There are dramatic differences in structure of the long ETFs and ETNs, even for the same commodity, leading to potential differences in performance and tax treatment.

Leveraged ETFs and ETNs are far riskier than simple long ETFs and ETNs. Their performance is often not what investors expect – see under Further Reading below.

ETFs and ETNs are treated differently for taxation purposes. Current opinion is that all gains on ETNs held for longer than one year are treated as long-term capital gains, whereas an investor owning a futures-based ETF is taxed on any capital gains on the underlying futures held by the fund using the taxation convention for futures, ie. at a hybrid rate of 60% long-term, 40% short-term each year on all gains, even if the investor doesn't sell the fund. (Check this carefully with your accountant.)